Recently Dan and I both started trying to read less military history because the books tend to be depressing. Knowing that I was going to be stuck on an airplane for a few hours and needing some light “by the poolside” reading I picked up A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers
A bit of background; Lehman Brothers is a famous financial firm that failed during the 2008 crisis and became the biggest bankruptcy case in US history, since it had a balance sheet of over $600 Billion in listed assets at the time of its collapse. Here is a wikipedia summary of the bankruptcy proceedings. Note that at the time of its bankruptcy Lehman had a 33-1 asset leverage ratio, meaning that only a small decline in asset values wiped out the equity and made the firm insolvent. The US Government declined to rescue Lehman Brothers, which remains controversial to this day, and the fall of Lehman also caused an immediate crisis at AIG which led to a huge US government backstop of $85B to halt further failures of other investment institutions.
While the book is interesting, the author, who is a trader, misses most of the essential elements of WHY Lehman was doomed to collapse, focusing on the remoteness of the CEO Fuld, the exposure to toxic real estate mortgages that couldn’t be “packaged” into assets and sold (because the securitization market had collapsed), and Lehman’s purchase of real estate at the “high water” time of 2007 (virtually everything bought in 2007 turned out to be a bad idea, look at your portfolio at the time).
Note that I think that the book is very interesting and entertaining and recommend that readers buy it. These are more “conceptual” than “literary” or typical journalism reviewer type concerns.
PUBLIC COMPANY CEO CAPTURE
However, these items are merely symptoms of the root cause. The author inadvertently stumbled upon the root cause while discussing the history of Lehman and Fuld’s rise to power, when disputes among the partners led to partners leaving the firm, taking significant amounts of their capital with them (the firm had to utilize their cash to buy back their stock).
When Lehman was spun back out as a public entity, in 1994, essentially the partners no longer mattered, regardless of their title, because Lehman was a public company and the board was “captured” by Dick Fuld. The board was admirably satirized in the book:
Nine members of the ten-person board were retired. Four of them were 75 years of age or older… only two of them had direct experience in the financial services industry – and they were all from a different era.
From this disparate group of old stagers, Lehman created a risk committee, chosen and controlled by Fuld himself. It met only a couple of times a year, which is an unusual way to monitor the company’s ongoing risk.
In addition to “capturing” the board and stuffing it with out-of-touch retirees, and nullifying its risk management capabilities, Fuld did what many CEOs do, installed a #2 who was in no position to challenge him to ever run the company.
A key factor in the appointment was that his ambitions did not apparently include becoming CEO. His great concern was with what he called the “culture” of Lehman Brothers.
Packing the board with retired and out-of-touch geezers, ensuring that no one competent is in place to succeed you, and limiting opportunities for your already-supine board to govern your actions are often immediate actions of CEOs that want to ensure their reign will be long and profitable (for themselves).
PUBLIC COMPANY “RACE TO THE BOTTOM”
The other myth in the book is that Lehman took extra-ordinary risks that wouldn’t have been made if someone else (other than Fuld) would have been at the helm, or if Fuld would have listened to any of the competent staff at Lehman (of which there were many, according to the author).
But in reality Fuld was just doing what all his competitors were doing:
– gorging on asset backed securities and earning easy profits (as long as the carousel kept moving)
– investing in hedge funds which were the latest craze
– directly purchasing real estate which only seemed to go up higher and higher
– leveraging up to insane proportions (at 33-1, they were typical)
– earning money from derivatives with counterparty risks (with counterparties such as AIG, Bear Stearns, etc…)
These same tactics (or close variants) were done by Citigroup, Merrill Lynch, Bear Stearns, Bank of America, and others. Goldman Sachs tried to get out a bit early but were singed and JP Morgan Chase under Jamie Dimon also were (relatively) well run shops by comparison.
If Fuld wouldn’t have done these things his stock would have been hammered and likely the board would have been forced to intervene and replace him with someone who WOULD move along with the herd. Thus Fuld really only could try to ride the tiger or get off and let someone else ride the tiger. From his perspective, and given that there seemed to be limited risk on the downside (unless the firm failed catastrophically, in which case he as CEO plus the CFO could be on the hook under Sarbanes for jail time if fraud was proven), he obviously chose to ride the tiger.
THE “SHERRON WATKINS” MYTH
Another type of “myth” is that if someone had explained the risk involved with the real-estate asset-backed securities to Fuld, then he would have pulled back the risk and saved the firm. This is analogous to the role of Sherron Watkins at Enron who told Lay about their accounting.
The book describes how Michael Gelband, who was the head of fixed income and by all accounts a seasoned veteran of Wall Street, tried to make the board and Fuld understand the risks that they were facing. Per the book:
The trouble was, Dick Fuld could not understand the technicalities of market finance at the highest level… the Chairman didn’t get it. But he realized he needed clarification. In front of Mike, he called Henry Paulson, the secretary of the United States Treasury and a former CEO of Goldman Sachs. Dick did not even try to get into the details of the problem, and handed the phone to Mike, who pointed out with immense clarity the serious problems recently developing in the asset-backed commercial paper market and its deadly potential impact on the giant leveraged SIVs, to which Wall Street and the largest commercial banks were exposed…. to this day, Henry Paulson, with a supreme grasp of the subject, insists that the first person ever to warn him of the coming catastrophe was Mike Gelband, of Lehman Brothers, in that phone call from Dick’s office.
And what was the response? Fuld basically told him to get with the program of higher leverage and bigger deals and ignore the risk so Gelband quit the firm.
While I do not want to compare Watkins, who was a relatively minor official, to Gelband, who is a big hitter on Wall Street and has gone on to other large roles, conceptually the hole in the logic is that even if Fuld (and Lay) understood the risks, they had no choice but to keep “riding the tiger” because that was how they made their money.
The book cited all the money that Lehman was making on CDOs – and as those traders earned more money they became even more important to Lehman. In real life they chose to resolve the conflict by “shooting the messenger” even if the messenger had been able to convince Paulson.
Cross posted at LITGM
The best I can tell is that there was no way to get off the ride first without serious harm. The basic problem was the zero effective real rates and the real estate bubble, both of which were the consequence of government policy. Panics happen in large economies but the government’s role is to try to prevent the panic and help the recovery, neither of which seems to have occurred.
I guess it is time to reread Nicole Gelinas’ book.
While every company has it’s own story, I think the real issue was a market distortion so vast that it swept everyone along with it.
In the old days, sometimes an entire fleet of close shore fishing boats would get swept out to sea. Usually, when out of sight of land, the boats could use their relative positions to each other to judge their location because the currents were fairly narrow and a boat that moved further out than the others would notice the change in relative location and sail back.
However, sometimes a very board current would occur that would move the entire fleet out in mass. The fishermen wouldn’t realize they had been carried far out to sea because all the boats moved out together while maintaining their relative positions.
The massive market distortion caused by the government assumption of risk in the residential real estate market essentially create a vast market “current” that carried a vast number of market actors in the same direction. Remember, we had a situation in which large numbers of financial companies began to make historical unprecedented profits for twenty years prior to the crash. Profits, leverage, exposure etc that once seemed risky and indicative of a company “far from shore” become viewed as normal if they persist for years or even decades.
The market responds to incentives and the government created a massive, broad and long-lasting incentive to make ever riskier loans. Companies that didn’t go with the flow appear to be mismanaged. Only companies that stake out a position of being conservative, even hyper-conservative, can resist such a tide.
Shannon, that’s a very good explanation.
There is an enormous gap between the popular/political understanding of the panic and the detailed facts and economic theory underlying a helpful analysis. The recent Angelides report (FCIC)was a good example. Basically it was a recitation of the blunders and screw-ups, and even a few out-right frauds that lead up to the event. But it was not an analytic framework that could be used to fix anything. see Keith Hennessey’s blog:
http://keithhennessey.com/2011/01/26/the-three-man-fcic-dissent-hennessey-holtz-eakin-thomas/
The part that you write about that interests me is the conversation between Michael Gelband and Hank Paulson. Not only was Paulson warned, but every regulatory agency had examiners sitting in the offices of every major regulated institution looking at their books as they collapsed in the summer of 2008. And yet, the regulators just sat and watched it happen without trying to formulate a plan to shore up the system if things got really rough.
The Dodd-Frank Act made no effort to address any of the real underlying issues. Indeed, I would argue that the pre-2008 law had every tool that the regulators needed. The most important fixes, much higher capital requirements for banks, severe curtailment of the less than 20% down, fixed rate, 30 year, no pre-payment penalty, mortgage, liquidating Fannie and Freddie, recognizing and regulating CDS as insurance, and ending the money market mutual fund anomaly, could all have been accomplished without new legislation except for a couple of minor amendments to the CFA regarding swaps.
While the causes are certainly many and complex I believe the regulations changing bank focus from the local markets to the macro set the stage in a large way.
In the not so distant past, banks could not operate across state lines. First this restriction was eliminated, then the lines between commercial and retail banking and investment banking were erased. The net effect was losing touch with reality.
Twenty five years ago a bank mortgage loan officer was evaluating loans for property in his own community, and was in a position to know when real estate prices and inventories of property had departed from common sense levels. Now with banks national and even global in scope, the loan decisions are based almost entirely on numbers, often not even by people but entirely by computers. Common sense and local knowledge are not part of the equation.
Prior to the collapse just about everyone saw real estate transactions in their own neighborhoods that caused them to shake their heads. Common sense told them there was simply no way that house was worth that much. In the past, if a ‘willing buyer’ wanted to do something that defied common sense the bank was postioned to assure that he was going to have to be stupid with his own money. That ability to apply a reality check on real estate transactions is lost.
In deregulating banks the machanism to save us from our own ignorance has been taken away. On the other side of the transaction, the loan that were often known at the local level to be dubious were bundled and sold to investors, again without the traditional mechanism to prevent stupid loans from being made in the first place. The upshot was a whole lot of loans that should never have been made – and twenty five years ago would never have been made – that went bad, and for almost every one of them the people living close to the property in question knew in their gut the loan was dumb.
The real economic and social travesty is that all of this would have been fine had it been part of a broad policy of letting the free market work its will – let buyers and investors beware. However, our national reaction, from government insuring many of the dumb loans to begin with to government rushing to provide a safety net for banks and investors – but not the buyers – has resulted in disater.
The economy will recover, but the social reaction to Washington saving the guys who bought the dumb loans, while leaving the people who took out the dumb loans high and dry will have long term repurcussions. Better to have bailed out everyone, or bail out no one, but to decide to bail out the by and large wealthy investors, but not the by and large less wealthy home buyers sows the seeds for deep social unrest. People who lost their home in a foreclosure – albeit of their own making – will be angry for a lifetime as they look at the financial institutions and see record profits less than two years later even though the fnanciers were equally willing and eually ignorant parties to the same poor financial decisions.
Bill,
How did the old regulations against interstate or branch banking help consumers? Who benefited when bank competition was limited?
I would argue that your points are red herrings. The Community Reinvestment Act forcing banks to lend to non-credit-worthy borrowers, and the maintenance of colossal off-the-books unhedged derivatives portfolios at Fannie and Freddie, for which the taxpayers were liable, were the main causes of the problem.
Jonathan,
I work as a manufacturing consultant and the impact has been substantial. The old regulations did not limit the number of banks in any state. There was plenty of competition, and in fact the big banks all had subsidiary banking companis in each state, but the regulations compelled bankers to work closely with local manufacturers – and other businesses – to find ways to grow the business. There was no difference in the level of competition, but it was more difficult for the banks to take capital from one region of the country and lend it into another region.
The Fed governor in Dallas has been quite vocal in pointing out that the banking changes have resulted in massive amounts of US capital leaving the US now that it is easier for banks to take your deposit in Hoboken and lend it to a big multi-national to build a plant in China. In the old days the banker would have had to work harder to find and develop loan worthy customers in Hoboken.
Certainly the massive subsidies to Fannie and Freddie were huge culprits, but the banks played a significant role too. It is convenient to ascribe the problem to a single main culprit, but not accurate or helpful to any discussion of the likelihood of similar debacles in the future.
From my small point of view, what I saw was a real estate market that was wildly out of the zone of reasonableness in price. There is a public golf course in San Clemente that I used to play every week. The fairways were lined with homes that sold for a million dollars. I used to wonder who bought those homes ?
My younger son is a fireman and a fireman friend of his had bought two expensive homes (In the $800,000 range), one as an investment. How does a fireman qualify for two such loans ?
I also knew some people who were in the mortgage processing and origination business. They were not particularly well educated and could care less what happened to the loans they wrote.
It all reminded me of the bond salesmen selling South American bonds in 1928.
Even I could see this was unsustainable. I considered selling my house and renting for a while but I had a daughter still in school. I had real estate agents who offered to buy my house. I know people who did that. It wasn’t that hard to see it couldn’t continue but it was hard to act on that suspicion.
Someone once asked Bernard Baruch the secret of his success. He answered, “I sold too soon.”
Bill Waddel,
In the not so distant past, banks could not operate across state lines
Yes and we suffered for it. Texas and many other southern states used to have highly restrictive laws against out of state banks supposedly to prevent capital flight and to protect the smaller economies of the agrarian south from the dynamic industrialized north.
What it did however was prevent capital from flowing in from out of state. Even if you had a local state boom, it could peter out because people couldn’t get enough capital to exploit it. Texas has special rules so that oil companies could get loans from out of state banks. After the oil bust, Texas began to de-socialize and one of the major changes was allowing interstate banking. Much of the boom of Texas in the last 20-30 years is directly linked to relative abundance of capital versus the old days.
You may complain of capital going to China but not to long ago people in the Northeast complained of capital going to Texas. I don’t think banking laws have anything to do with it. Capital goes where the productivity and economic action is. If you have capital leaving your community, regardless of the scale of the community, then the community screwed up. If people can’t make good enough use of capital to keep or attract capital without artificial restraints on capital flow, then don’t know how to put the capital to good use anyway. If you give them more capital, they will just waste it. Keeping capital local simply causes it to rot.
I mean, do you really think Detroit would be better off if we made it illegal for Detriot banks to lend anywhere outside the city?
Certainly the massive subsidies to Fannie and Freddie were huge culprits, but the banks played a significant role too. It is convenient to ascribe the problem to a single main culprit, but not accurate or helpful to any discussion of the likelihood of similar debacles in the future.
I really don’t. To me, that’s pretty much like blaming the collapse on “greed” which is pretty much like blaming a building collapse on gravity. Greed is a universal constant and so are scams, unethical boundary pushing, incompetent regulators and reckless experimentation. You have to have a system, which really means an incentive structure, which assumes that people will constantly be doing those things. By closely tying the risk of loss to the risk of loaning, the free-market creates an incentive structure that compels people towards financial conservatism.
Without the mass distortion of the market, none of the other shenanigans would have caused any major harm. After all, financial institutions get into trouble all the time for just those things. They just look important because we usually only see them when something major happens.
Robert Schwart,
Indeed, I would argue that the pre-2008 law had every tool that the regulators needed.
They did it was just the political will to regulate that was lacking. The problem was, any regulation that would have headed off the problem would have reduced the number of mortgages issues and reduced the number of voters who became home owners. When every politician is leaning on the gas pedal they don’t look to kindly on regulators that want to slow things down.
The Democrats launched a massive effort against Bush’s two attempts to reign in Freddie and Fannie and they justified it explicitly on the basis that making Freddie and Fannie’s practices more conservative would reduce the number of people who got homes.
Basically, the politicians told the regulators to make sure that banks continued making loans the free-market judged as risky but to simultaneously make certain that the banks never made any risky loans. Overtime, the contradiction tilted ever stronger towards the former over the latter.
We could have given the regulator the right to shoot bankers in the street on a whim but as long as issuing home mortgages was the governments overriding goal, the regulators could have never stopped the collapse. Any attempt to do so would have provoked an instant and powerful political backlash.
Shannon, I like your arguments about the Texas economy (I like most of your arguments about things). But, it occurs to me that you could be a valuable asset to some political leader who needs an adviser. I am really praying for good people to be placed in positions of leadership. It is fun to hash ideas around, but we need people with vision who are able and willing to get into leadership and do a good job. It seems to me like you have the ability to see a big picture and hone in on what is important. So, here is me encouraging you to seek out the opportunity to get involved (or perhaps accept any offers you may have on the table).
I like the comment threads here they are very intelligent.
One of the core ideas to my post is that sometimes you don’t have to be very intelligent to run a major enterprise. You just need to be ruthless with COMPETENT successors, pack the board, and appoint incompetent successors who get focused on side projects like “culture” and “diversity”. Then you just ride along with what everyone else is doing until it collapses. All along, you get paid.
A lot of the people on this thread seem to be in business for themselves or independent thinkers or traders.
They really can’t believe what it is like to be part of an institution that is run directly into the ground in a predictable and painful way on shareholders’ money. It is such a slow motion train wreck, but in the end it is a wreck.
The author of this book couldn’t believe that this is the main element of the story, either, and he kept looking for ways Lehman Brothers “the company” could be “saved”. But the CEO Fuld cared about himself and his cash and that meant running the company in the manner in which it was run, so there was not going to be any significant changes until right at the end when there was nothing to do to save the company anyways.
Shannon,
You don’t see a difference between US capital going to China and Massachusetts capital going to Texas?
Your speil about productive use of capital leades me to think you might be one of those naive souls who thinks US capital and manufacturing going to China is Ricardo’s theory in action.